Can Gold and Interest Rates Move Higher at the Same Time?

Can the gold price be fundamentally related to some other economic variables?
Can we use those variables successfully in trying to predict the future price
of gold? Is gold highly correlated with any of those variables?

Last year a very insightful and interesting
working paper was published in the webpages of the National Bureau of
Economic Research by Claude Erb and Campbell Harvey. The paper is mostly
about gold being perceived as either a safe haven or an inflation hedge.
After a while it sparked various discussions about gold not being what it
is thought of. And rightly so. As we have already mentioned many times in
the Market
Overviews, gold is not historically an inflation hedge device which will
protect you against possible inflation. Of course the special case for the
gold price could be a hyperinflationary scenario.

In the same paper Erb and Harvey have found a very interesting correlation
in the gold market that lies between the gold price and the interest rates. If
real interest rates rise, then gold falls. If real interest rates fall, gold
gains. In itself this relationship is nothing new for gold analysts.
This observation about gold related to the interest rates has been floating
around for some time. It is perfectly understandable since there are good explanations
for the phenomenon, and (as opposed to the inflation-hedge hypothesis) this
one actually has some confirmation in the data.

Erb and Harvey did a comparison of the real price of gold to TIPS - Treasury
Inflation Protected Security - to ten-year government bonds, which are adjusted
by the inflation rate. The correlation seems to be very high, especially in
the realm of economic data - 0.82! This is pretty high if we compare it with
numerous other correlations done in various fields of study.

It is no surprise then that the previously existing theory has been boosted
again. Despite the fact that the authors of the paper were very careful and
reserved in drawing any serious conclusions from this observation, some of
those inspired by the research already attempted to use those observations
to predict future gold movements. We could read predictions that if you
expect gold to come closer to 2 thousand dollars per ounce, then we should
see interest rates first coming lower under the one percent level. At least
that's what the numbers are telling us, and the numbers could not possibly
lie to us, could they? Perhaps I forgot to mention that all those predictions
have something smuggled in a very smooth and elegant way, which comes down
to "provided that history is good guidance..."

Is it in this case?

Actually an observed correlation relates only to the most recent 17 years.
That is not that much when it comes to determining long-term relationships.
And it can be explained in a different manner. As we emphasized, gold should
be treated as a specific currency in the financial market. It is a dollar alternative.
Therefore anything that happens to the dollar economy, any negative sign of
its weakness will favor gold, and boost its value. Therein is the reason why
low real interest rates were so often associated with gold's increases in value.
When the American economy is weak, interest rates are often lowered because
of the responsive monetary policy of the central bank. Hence there may have
been a common denominator for low interest rates and high prices of gold: bad
times for the dollar economy. With distrust in dollar assets, investors get
more interest in the shiny asset, and bureaucrats are ready to print money.
Those two things perfectly coincide.

Actually any sensible story about investing in gold could be translated into
the comprehendible story within the margin.

How is that relevant for the current gold investor? As simple as this: even
if the interest rates are raised, it does not mean that gold's bull market
has to be over. Even if the returns on government bonds go up significantly,
the gold market need not be decimated because of it. And the other way around.
Just because interest rates are at low levels and will stay at significantly
low levels (as Yellen tries to assure us), it does not mean that gold is the
safest investment on a short-term basis (as recent experience in the market
a few months ago has confirmed). Every such change has to be interpreted in
the context of the economic situation. We also have to remember that interest
rates are a very complex phenomenon.

It is not hard to imagine a scenario in which long-term interest rates are
going up, and gold is still booming. In fact it is quite easy. Can there be
the case of more distrust in the dollar system and increasing returns on government
bonds? Yes, there can be such a scenario. For example, it can simply happen
when investors also start distrusting US Treasuries, and not only other (mostly
commercial) dollar assets (which could happen if inflation was very high, and
in the end a huge outflow of capital from United States would result). Plus,
in the previous bull market (70's), interest rates simply followed gold higher.

All in all, the main reason behind gold's bull market is the failing dollar
system. The Fed's interest rate policy is a way to deal with this epic problem
and gold's performance is mainly the consequence of the latter, not the former.
It therefore seems that the interest rate environment will continue to support
higher gold prices, but one should keep in mind that the gold-interest-rates
link is not carved in stone.

Matt Machaj, PhD, is an economist whose research is focused on the monetary
policy, the gold standard, and alternative monetary regimes. Matt is a university
professor, blogger, publicist, founder of the Polish Mises Institute branch,
member of Property and Freedom Society, and laureate of Lawrence Fertig Award.

He is a free market advocate, believes in personal liberty, responsibility,
and believes that social power is a better alternative than government power.
Personally he believes that intelligence is the most powerful thing in the
universe and beyond. He is no fan of conspiracy theories, but likes to study
conspiracy practices.

You can read Matt's premium analysis at Sunshine Profits, where he publishes
his gold
Market Overview - monthly reports that focus on the big, fundamental
picture and key things that can affect investors over the long run.

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